Execute A Diagonal Bull Call Spread : Long ITM Call & Short OTM Call

Introduction To Diagonal Bull Call Spread

A diagonal bull call spread is created by buying and selling call options with different expiration dates. A trader will buy an in the money long term call option and selling an out of the money short term call option to create a diagonal bull call spread. As the short term option expires, the trader gets to keep the premium on the short term call option while allowing the long term call to increase in value when the underlying security moves up over the longer term.The call options involved have different strike(exercise) prices, different expiration dates and are derived from the same underlying security. The rationale for writing a short term call option is to take advantage of the eroding time value. To understand more, read : Theta

Net Debit

A net debit is needed to create a diagonal bull call spread because the longer term option costs more than the short term option.

Margin requirement

Margin is required to execute a diagonal bull call spread. The amount of margin is determined by the broker that a trader uses. This should be verified with your broker before you execute the diagonal bull call spread.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook : Slightly Bullish In Near Term But Bullish In Long Term
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Understand That A Diagonal Bull Call Spread Has Limited Loss Potential
Step 7 : Understand That A Diagonal Bull Call Spread Has Limited Profit Potential
Step 8 : Calculate Profit
Step 9 : Calculate Risk & Reward Ratio
Step 10 : Set Up Trade : Executing the bull call diagonal spread
Step 11 : Exit Trade
Step 12 : Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

In order to arrive at a conclusion of the general direction of the markets and the underlying security, an options trader should conduct some economic, fundamental and technical analysis. Economic analysis will tell a trader about the general direction of the broad market. This in turn affects the general direction of the underlying security. Fundamental analysis is performed to put a target price on the underlying security. And last but not least, technical analysis will help a trader to determine optimal entry and exit points. Some chart patterns to look out for are :

To be clear on this, the trade should be executed before the breakout occurs so that the written options expire worthless. Do note that the above chart patterns are just suggestions.

Please read our articles on economic analysis, fundamental analysis and technical analysis.

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Step 2 :Outlook : Slightly Bullish In Near Term But Bullish In Long Term

After performing economic, fundamental and technical analysis, the options trader should arrive at a conclusion that the markets are slightly bullish in the short term and even more bullish in the long term. These are conditions suitable for executing a diagonal bull call spread. The rationale for buying long term calls and writing short term calls is to capture upside in the longer term while earning premium in the short term.

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Step 3 :Study the option chain

Now, the options trader should study the option chain and select strike prices of call options that can be used in the diagonal bull call spread. The selection of option contracts should reduce the net debit paid for the spread.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

Next, breakeven analysis can be performed to find the breakeven point for the diagonal bull call spread strategy. This can be done with the help of software.

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Step 5: Understand Your Profit Zones

After the breakeven analysis has been performed, one is able to identify profit zones, that is, prices at which the underlying security must trade at in order for profits to be realisable. The  simplistic way of looking at diagonal bull call spreads is this. Ideally, the short term OTM call option should expire worthless. After which, when the price of the underlying security increases, the long ITM call will capture its upside.

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Step 6 : Understand That A Diagonal Bull Call Spread Has Limited Loss Potential

The diagonal bull call spread is a debit spread, that is, a net premium is paid to execute the strategy. This is because the long term in the money call is more expensive than the short term out of the money call. The maximum loss is thus the debit created when the spread was created.

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Step 7 : Understand That A Diagonal Bull Call Spread Has Limited Profit Potential

The profit potential of the diagonal bull call spread is limited at any point in time. If the price of the underlying security  is stagnant, the written call will expire worthless. This allows the trader to collect the premium. He can repeat the process again by writing out of the money call options at a higher strike(exercise) price. By  doing so, the trader gets to collect monthly premiums.

However, when the shorted call expires worthless, the trader only has a long position in a call option. As the underlying security price rises, the value of the call option will increases as well. From a call buyer’s perspective, potential profits are unlimited.

When the time is right, the trader may choose to let the OTM call expire worthless and not write another OTM call. Instead, he just lets the price of the underlying security increase and the he can sell to close his long call at a profit that is unlimited.

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Step 8 : Calculate Profit

Assuming that the short call expires worthless while the long call increases in value as the underlying security reaches your price target, you are able to estimate the amount of profit.

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Step 9 : Calculate Risk & Reward Ratio

Since the maximum loss is limited to the net debit, when one is able to estimate the realisable profit, one is able to do a risk and reward analysis. Does the potential profit justify the risk according to your experience? Is it favorable compared to other trades?

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 10 : Set Up Trade : Executing the bull call diagonal spread

The spread is executed by buying a long term in the money call option and writing an out of the money call option at a higher strike(exercise) price. The ratio of long ITM calls to short OTM calls is 1:1. A net debit is created when the spread is executed because the in the money calls are worth more than the out of the money calls.

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Step 11 : Exit Trade

An options trader can continuously write OTM calls as each short term call expire worthless and allow the long term call to increase in value after a significant increase in the price of the underlying security. If there is no possibility of the price of the underlying security increasing significantly, the diagonal bull put spread can be offset to mitigate the effects of time value for the long call position. This is especially so if there is less than 30 days till the expiry of the long call position.

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Step 12 : Record Trade In Diary

After the trade has been offset, record it in a trading diary. At this stage, the options trader should analyse the entire trade from start to end, from research to execution and eventual profits. Was the trade successful? Can this be replicated consistently? Every trader should ask questions to make themselves better traders.

Example

RTY Corp is currently trading at a price if $27. A trader decides to buy a long term October 25 call at $4 and write a July 30 at $2.

The net debit created can be calculated as :

($4 – $2) x 100 = $200

If the price of RTY corp stagnates at $27, the OTM call will expire worthless. In that case, he gets to keep the short call premium of $200. He can choose to write an OTM call repeatedly for several months till the price of the underlying security reaches his target price. If he does so, the collected premium from writing the OTM call monthly has the effect of reducing the price of the long call. For example, if an OTM call is written as the  price of RTY rises gradually and reaches $35 on the expiry date of the long call, the trader stands to collect a total of 4 months x $200 = $800 of premium from writing OTM calls. (This is an approximate figure. The real world is much more complex) Effectively, his long call becomes free as the net debit is less than the total amount collected from the short calls.

Calculated profit is thus equal to = ($1000 – $400)(gain in long call) + $800(collected premium) – $200(debit created to enter trader initially) = $1200

If the price of the underlying security drops to $20 on expiration date of the October 25 call, all options in the spread expire worthless assuming that the trader does not keep writing OTM calls monthly. The trader loses $200 which is equal to the net debit created at first.

Read : Executing A Bull call spread

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